When safety proves dangerous …

… is the title of a post on the Farnham Street blog that provides a useful reminder of the problem of “risk compensation”; i.e. the way in which measures designed to make us safer can be a perverse prompt for us to take more risk because we feel safer. I want to explore how these ideas apply to bank capital requirements but will first outline the basic ideas covered by Farnham Street.

we all internally have a desired level of risk that varies depending on who we are and the context we are in. Our risk tolerance is like a thermostat—we take more risks if we feel too safe, and vice versa, in order to remain at our desired “temperature.” It all comes down to the costs and benefits we expect from taking on more or less risk.

The notion of risk homeostasis, although controversial, can help explain risk compensation.

The classic example is car safety measures such as improved tyres, ABS braking systems, seat belts and crumple zones designed to protect the driver and passengers. These have helped reduce car fatality rates for the people inside the car but not necessarily reduced accident rates given that drivers tend to drive faster and more aggressively because they can. Pedestrians are also at greater risk.

Farnham Street suggests the following lessons for dealing with the problem risk compensation:

  1. Safety measures are likely to be more effective is they are less visible
  2. Measures designed to promote prudent behaviour are likely to be more effective than measures which make risky behaviour safer
  3. Recognise that sometimes it is better to do nothing if the actions we take just leads to an offset in risk behaviour somewhere else
  4. If we do make changes then recognise that we may have to put in place other rules to ensure the offsetting risk compensating behaviour is controlled
  5. Finally (and a variation on #3), recognise that making people feel less safe can actually lead to safer behaviour.

If you are interested in this topic then I can also recommend Greg Ip’s book “Foolproof” which offers a good overview of the problem of risk compensation.

Applying these principles to bank capital requirements

The one area where I would take issue with the Farnham Street post is where it argues that bailouts and other protective mechanisms contributed to scale of the 2008 financial crisis because they led banks to take greater risks. There is no question that the scale of the crisis was amplified by the risks that banks took but it is less obvious to me that the bailouts created this problem.

The bailouts were a response to the problem that banks were too big to fail but I can’t see how they created this problem; especially given that the build up of risk preceded the bailouts. Bailouts were a response to the fact that the conventional bankruptcy and restructure process employed to deal with the failure of non-financial firms simply did not work for financial firms.

It is often asserted that bankers took risks because they expected that they would be bailed out; i.e/ that banks deliberately and consciously took risk on the basis that they would be bailed out. I can’t speak for banks as a whole but I have never witnessed that belief in the four decades that I worked in the Australian banking system. Never attribute to malice what can be equally explained by mistaken beliefs. I did see bankers placing excessive faith in the economic capital models that told them they could safely operate with reduced levels of capital. That illusion of knowledge and control is however a different problem altogether, largely to do with not properly understanding the distinction between risk and uncertainty (see here and here).

If I am right, that would suggest that making banks hold more capital might initially make them safer but might also lead to banks looking for ways to take more risk. This is a key reason why I think the answer to safer banks is not just making them hold higher and higher levels of common equity. More common equity is definitely a big part of the answer but one of the real innovations of Basel 3 was the development of new forms of loss absorbing capital that allow banks to be recapitalised by bail-in rather than bail-out.

If you want to go down the common equity is the only solution path then it will be important to ensure that Farnham Street Rule #4 above is respected; i.e. bank supervisors will need to ensure that banks do not simply end up taking risks in places that regulation or supervision does not cover. This is not a set and forget strategy based on the idea that increased “skin in the game” will automatically lead to better risk management.

Based on my experience, the risk of common equity ownership being diluted by the conversion of this “bail-in” capital is a far more effective constraint on risk taking than simply requiring banks to hold very large amounts of common equity. I think the Australian banking system has this balance about right. The Common Equity Tier 1 requirement is calibrated to a level intended to make banks “Unquestionably Strong”. Stress testing suggest that this level of capital is likely to be more than sufficient for well managed banks operating with sensible risk appetites but banks (the larger ones in particular) are also required to maintain a supplementary pool of capital that can be converted to common equity should it be required. The risk that this might be converted into a new pool of dilutive equity is a powerful incentive to not push the boundaries of risk appetite.

Tony – From the Outside

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

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